HIGH & LOW FINANCE; Commercial Mortgages Show How Bad It Got

By FLOYD NORRIS

Published: July 6, 2012

CORRECTION APPENDED

Just five years ago, the commercial real estate market was thriving. The delinquency rate on mortgage loans was at a record low, and the volume of new mortgages being sold to investors was at a record high.

Now the first of the mortgages that were securitized in 2007 have started to come due, and it is becoming clear just how bad many of the loans were. The time when investors were most eager to buy turns out to have been the worst time to do so.

Commercial mortgages -- unlike residential ones -- are seldom issued for periods of longer than 10 years, and often for as little as five. Many require no principal repayments during that period but call for the entire amount to be repaid in a balloon payment at the end of the loan. So it can be at maturity when the bad news arrives.

''Only 28 percent of the loans from 2007 due to mature in 2012 managed to pay off in full,'' said Manus Clancy, the senior managing director at Trepp L.L.C., which monitors the commercial mortgage market.

Other loans in those securitizations were for seven or 10 years, so new waves of losses may arrive in 2014 and again in 2017.

Perhaps no loan that was securitized in 2007 illustrates the craziness of the market at the time better than one for a group of apartment buildings in Manhattan. The 36 apartment houses, principally owned by the Praedium Group and managed by the Pinnacle Group, run by Joel S. Wiener, had produced cash flow of $5.4 million in 2006, but they secured a loan of $204 million, on which annual interest payments of $12.7 million would be required.

How could such a loan be justified? The prospectus said Deutsche Bank made the loan based on forecasts that by 2012 the cash flow would have soared to $18 million a year, as market rents in New York rose rapidly while many tenants in rent-stabilized and rent-controlled apartments moved out. It assumed that the owners' expenses would barely increase while rents soared.

The way the bank did the math, those apartment buildings were worth $255 million, so the loan was for only 80 percent of market value.

In court papers, Mr. Wiener has since asserted that Deutsche Bank expected he would be able to convert the buildings, many of them five- and six-story walk-ups, into condominiums.

That loan turned out badly for the securitization that bought it from the German bank, but it also appears to have turned out badly for many tenants in the more than 1,000 apartments. To meet the mortgage payments, the owners needed to come up with a lot more cash than the current tenants were obligated to pay under their leases and New York law. Mr. Wiener may not have needed any incentive to harass tenants to leave, but the loan provided one.

By the time the loan was made, Mr. Wiener's reputation as a landlord controlling more than 21,000 apartments in New York City was so notorious that it had attracted several investigations, including one by the New York attorney general. Betsy Gotbaum, the city's public advocate at the time, had asked Richard F. Levy, a senior partner with the Chicago law firm of Jenner & Block, to represent tenants pro bono in a suit contending that Pinnacle routinely harassed and intimidated tenants and illegally sought to evict thousands of them. That suit was later filed and has since been settled on terms that could force Pinnacle to reduce rents for many tenants and to pay damages to others who say they were harassed, although Pinnacle did not admit doing anything wrong.

The loan went into default in early 2009, but Pinnacle continued to run the apartments. In November, the securitization sold the loan for $116.7 million. Ben Carlos Thypin, the director of market analysis at Real Capital Analytics, calculates that after all fees are considered, ''the net loss to bondholders was 49 percent of the original loan balance.''

Now the apartments are being run by a court-appointed receiver while the new owner of the loan fights in court with Pinnacle over control of the buildings.

Mr. Wiener's office said he was traveling and unavailable for comment.

This loan defaulted relatively quickly, but many others in securitizations can now be viewed as zombie loans. They appear to be alive, but in reality they are dead. That is the case because many properties are producing enough cash to cover the monthly interest payments, which is all that are typically due before maturity, but are not worth enough to enable the loan to be refinanced.

That leaves the securitization with some difficult decisions. If it forecloses, who will operate the property until it can find a buyer? And what price will that buyer pay? It may seem wise to modify the loan, or to simply extend it. Or to pretend that the loan is good so long as some cash is coming in.

Trepp reports that 61 percent of the commercial mortgage-backed securities loans that should have been repaid this year are still outstanding. Half were extended or otherwise modified, while the other half are zombies -- not modified but continuing to exist.

Over all, more than 10 percent of loans in C.M.B.S. portfolios are now delinquent, according to Trepp calculations. The worst category is apartment loans, with a delinquency rate of 15 percent. In early 2007, when the current crop of bad loans were being made, less than one-third of 1 percent of existing loans were delinquent.

For investors in the General Electric securitization that contained the loans on the Manhattan apartments, not all the news has been bad. The way securitizations work is that some tranches of securities take the first losses, while others are secure until the lower-ranking tranches are wiped out. So some investors are still receiving the promised payments, and some tranches still have AAA ratings -- an indication that Moody's thinks they are still safe.

Borrowers are current on their payments on less than one-third of the $3.1 billion of loans still left in the securitization, and more than 80 percent of the properties securing those loans are thought by Wells Fargo, the trustee for the securitization, to be worth less than the amount owed.

The boom in commercial mortgage-backed securities in the middle of the last decade provided a lot of money for underwriters, enabled banks to earn fees from making and servicing bad loans and allowed property owners to withdraw large amounts of cash. The losers were the investors and -- in far too many cases -- the unfortunate tenants.

This article has been revised to reflect the following correction: The High & Low Finance column on July 6, about commercial mortgage securitizations, misstated the financial returns of the refinancing of 16 Manhattan apartment buildings to their owners, the Praedium Group, which was the principal owner, and Joel Wiener of the Pinnacle Group, who was manager and part owner. The owners did not take cash out in the 2007 refinancing, and thus did not realize a profit; it is not the case that they ''probably will walk away with a huge profit'' despite defaulting on the loan.

An earlier version of this column also misidentified the owners of a group of apartment buildings in Manhattan. The buildings were principally owned by the Praedium Group -- not by Joel Wiener and his company, the Pinnacle Group, which managed the buildings and held a 5 percent stake. The column also described incorrectly part of a prospectus for the securitization of a mortgage loan on the buildings. The prospectus did in fact disclose that Mr. Wiener's company was under investigation for its practices as landlord; it is not the case that the prospectus did not make that point.